If you’ve been following the recent financial headlines, you’ve seen that the stock market has been quite volatile. Trading days with large declines have been accompanied by news stories and headlines that warn of a coming recession. As of the market close on Thursday, August 15, the S&P 500 is down 5.9% since its all-time high reached on July 26 of this year. Year to date through August 15, the index is up 14.6%.
It has been over ten years since the last recession ended. It is true that a recession is coming but when is a much trickier question to answer. We know recessions can be complicated and we know many of our clients have questions. We’d like to try to answer some of those questions here. Let’s start at the beginning.
In simple terms, a recession happens when the economy stops growing and starts shrinking. More technically, economists generally define a recession as two or more consecutive quarters of falling GDP. GDP, or Gross Domestic Product, is the total value of all goods and services produced and is often used to measure the size of an economy. Watching the rate of growth or decline in GDP is an easy way to gauge economic health.
Fundamentally, a recession starts when consumers and businesses start spending less either because they have less to spend or because they expect difficult times ahead. It is usually a confluence of factors that could include excessive debt, rising interest rates, inflation, mismanagement, asset bubbles, or government intervention.
Part of what makes recessions so hard to predict is that there can be many reasons for a recession to start. The Financial Crisis of ’07-’09 started because too many bad loans were made to home buyers who ultimately couldn’t afford their payments. The recession of the early 2000’s occurred due to the popping of the dotcom bubble, the 9/11 attacks, and a handful of accounting frauds. Perhaps more ominous for today’s situation, the Great Depression started with a collapsing stock bubble but really intensified as a result of a trade war spurred on by the Smoot-Hawley Act of 1930.
When corporate profits begin falling, recessions can tumble into a self-reinforcing cycle where we see the following:
Finally some good news. Recessions don’t usually drag on for years and years, while economic expansions do. Since 1900, there have been 22 recessions ranging in length from six months in 1980 to 43 months during the Great Depression. Since the end of World War II, recessions have lasted less than a year on average. Meanwhile, economic expansions have usually persisted for several years.
Recessions are important for stock returns as the market generally reacts positively or negatively to changes in the health of the economy. Ideally we would be able to reduce our exposure to stocks in anticipation of a recession and then increase our exposure to stocks in anticipation of the subsequent resumption in economic growth. The tricky part in calling a recession is that stocks tend to start falling before the economy has peaked. To complicate matters more, the stock market dips by some amount almost every year, even when there aren’t recessions (see chart below, Annual returns and intra-year declines). Nearly all recessions are preceded by a market selloff but not all market selloffs precede a recession.
Further complicating an effort to time a recession, stocks also tend to start recovering before the economic rebound begins. History has demonstrated that it is exceedingly difficult to time the market and move out of stocks as a recession is starting and then move back into stocks as the economic recovery begins. We don’t know of any investor able to do this with any sort of consistency. As famed money manager Peter Lynch once said, “It would be wonderful if we could avoid the setbacks with timely exits, but nobody has figured out how to predict them.”
This is a question we’ve been hearing a lot recently (though we heard the same question on numerous occasions over the past decade). Unfortunately, this is a difficult question to answer, even for professionals whose job it is to track the economy. We’ve all certainly seen and heard a lot of these “professionals” on television or online making bold predictions over the last few weeks as the market has gyrated. As CNBC or Fox Business knows, “If it bleeds, it leads.” Trotting out the expert who is predicting a recession doesn’t sell too well when the market is moving up. But after a few big declines, nothing grabs a viewer like a forecaster of doom. Our fear kicks in and we feel we must “do something.” Stop and remind yourself: If you’re reading or hearing about it, the market already knows it. Stock prices already reflect that information. As they say, “If it’s in the headline, it’s in the price!”
Once again we’ll say that it is hard to predict when a recession will begin. There are, however, some indicators we watch that can be useful in gauging the health of the economy. No one indicator is predictive enough on its own but when several start to flash red, the odds of a recession begin to rise.
The indicator grabbing the most headlines about the economy over the past week is the dreaded “inverted yield curve.” An “inversion” is when the yield on short-term bonds is higher than the yield on long-term bonds. The yield curve is currently inverted. This has happened prior to every recession over the past five decades. An inverted yield curve is a negative indicator because it implies that investors expect interest rates to be lower in the future. These investors would prefer to buy long-term bonds with lower yields than short-term bonds with higher yields. These investors prefer to buy the longer-term bond to lock in the (albeit lower) interest payment for a long period of time rather than buy the short-term bond (with an albeit higher interest rate) knowing the short-term bond will mature much sooner and they’ll be forced to reinvest at much lower interest rates. The key is the signal this sends. The signal is that there is an economic slowdown coming and this signal shows up in the decline of long-term interest rates. On August 15, the ten-year US Treasury bond yield fell to 1.54% and the 30-year Treasury dipped to 2%, a record low yield.
While the inverted yield curve has been a fairly reliable warning sign that a recession is coming, it hasn’t done as well predicting when the next recession will arrive. Recessions have tended to start more than a year after the yield curve inverts.
Employers start laying off employees when profits fall. While the yield curve tends to invert and the stock market tends to peak far in advance of a recession, unemployment begins rising right at the beginning of a recession. On this note, the employment situation in the US is quite healthy; unemployment is currently sitting at 50-year lows. According to the latest reports by the Bureau of Labor Statistics, there are currently 7.3 million job openings compared to about 5.2 million unemployed people looking for work.
When confidence falls, consumers tend to cut back on spending and credit card usage. While consumer confidence has stopped rising over the past year, it has held steady. And consumer spending, which makes up more than two thirds of US economic output, has held up well. The Commerce Department announced on August 15 that July retail sales climbed 0.7% from the prior month, the strongest reading since March. The Atlanta Fed said the retail-sales report caused it to raise its estimate of third-quarter growth. Its GDPNow real-time growth estimator now stands at 2.2%, up from 1.9% in the August 8 estimate. This follows GDP growth of 3.1% and 2.1% in the first and second quarters respectively.
Headlines have noted lately that consumer debt is at an all-time high. This is true, but the same can be said for household net worth. Importantly, while consumers have higher debt outstanding, their debt payments as a percentage of income are in a healthy range as a result of lower interest rates.
Manufacturing and housing reports haven’t been as rosy as consumer spending reports. Trade-related headwinds, sluggish global growth and a strong US currency that reduces demand for US exports have crimped manufacturers this year. The Federal Reserve announced on August 15 that US industrial output in July fell 0.4% from a month earlier. Housing prices and home sales have declined over the last year as some parts of the country have seen demand fall. Especially hard hit are parts of California which had experience the hottest growth prior to the slowdown. According to the National Association of Realtors (NAR), existing home sales in June declined 1.7% from the prior month and 2.2% for the full year. The next housing report is expected to be released on August 21.
The micro-economics of individual companies are beginning to reveal internal pressures on margins. Top line revenue growth appears scarce for many companies due to the weaker global economy and the uncertainty created by the trade war. 2019 earnings growth will likely be meager compared to the outstanding numbers posted in 2018. Juiced by the 2017 tax cuts, S&P 500 earnings grew by more than 20% in 2018. The comparisons are proving to be trickier in 2019. FactSet predicts earnings growth of just 1.5% this year. This of course brings into question the sustainability of indefinite rosy market expectations and likely explains some of the volatility of late.
While there are some warning signs of a recession on the horizon, the indicators are a mixed bag. The economic cycle is still with us and we know we’ll experience a recession at some point. The market will decline, the economy will weaken, jobs will be lost and the news will be bleak. And then the market will turn up and an expansion will begin. We don’t know when these events will happen. But they will happen.
We don’t try to make adjustments to our portfolios in anticipation of economic events. Expansions tend to run for much longer than contractions and the risk in being wrong and on the sidelines can be very expensive. Staying the course and riding out a market decline and recovery can be painful but it’s far less harmful to your portfolio than being in cash while the market goes away from you.
So are we saying investors should sit by and do nothing? Of course not. Now is as good a time as any to make sure your asset allocation is appropriate for your needs.
Your personal asset allocation should provide you with enough liquidity to cover your cash needs in case the market does tumble. If you are dependent on your portfolio for your cash flow or if you expect to be dependent on your portfolio in the near term (five years), we advocate having enough liquidity in your portfolio (bonds and cash) to easily make it through a lengthy market decline. If you would like to discuss your portfolio allocation, please give us a call.
The truth is we worry about recessions and bear markets as much as you do. As Frank Bragg reminds us at Bragg Financial, “Our clients pay us to worry about the market so they don’t have to!” Having an appropriate allocation and a long-term perspective will get us through recessions when they come (and they will).
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.